Attorney R. Tamara de Silva's Blog

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Mark Twain

Risk management is the difference between success and ruin in the financial markets. As Nassim Taleb so succinctly stated, “risk is what can really hurt you.” It is arguably the single most important consideration for any participant, from the single independent trader to the juggernaut of a Goldman Sachs in the financial markets.

But what is risk? There are many discussions of what constitutes risk in the financial markets but not surprisingly, there is no one definition. Typically, discussions of risk revolve around the concepts of Value at Risk (VAR), beta, delta, the capital asset pricing model (CAPM) and the Black-Scholes options pricing model (BSM). All these ways of quantifying risk are based on inarguably faulty assumptions. The recent credit crisis and mortgage meltdown is another example of how Wall Street’s methods of modeling market behavior and accounting for risk, are fundamentally flawed.

Do you know what a Gaussian Bell Curve is? Most MBA types who go on to work at and eventually run investment banks do. There are really only two things you need to know about a Gaussian Bell Curve. A Gaussian Bell Curve assumes events occur in a normal distribution. What this means is that in a Gaussian Bell Curve, if events or occurrences were plotted, they would occur in the largest numbers at or towards the very center of the bell curve. All these events, plotted on a chart would take the shape of a bell curve, hence the name. Events which occur less frequently would occur towards the edges of the curve. The further the event was from the center of the bell curve, the more improbable it is to occur. This is called a normal distribution. The second thing one should know about the Gaussian Bell Curve is that it does not predict market events very well at all. In fact, knowing what it is, you may disregard it completely.

Analysts at investment banks make models of reality with predictive capability. It is true. How one may ask, can you make a model of realty that is able to predict market movements and price, without having God-like prescience? Do not be skeptical, it is not that difficult and it happens all the time-you can be an analyst at an investment bank. It is called modeling. J. P. Morgan invented Risk Metrics in 1994 as a set of financial models that were to be used by investors to measure portfolio risk. Risk Metrics like financial modeling in general, attempts to take a certain set of variables or causes and isolate them as being the very variables that account for change in financial markets. This is a bit simplistic but nonetheless true. Financial models seek to replicate financial reality much like economic models and models of human behavior that have become extremely popular in the social sciences writ large.

Humans do not like indeterminacy. We do not like to make decisions or look back in hindsight and think we made decisions by tossing a coin. On the contrary, we like to find reasons for why we made decisions and why events occurred. We tend to think we can. We have at times an irrational belief in the rational. But as Pascal once stated, nothing is more rational than the abdication of reason itself. The ability of social scientists or investment bankers to explain events through the actions of rational human actors appeals to our psyche. It is appealing to think we can.

Models of the financial markets like models of the human behavior in the social sciences have serious limitations. To start, they have to simplify reality. One of the ways that modeling simplifies and in a sense, falsifies reality is by making assumptions about human beings, which are not true. For example, modeling tends to assume that humans, whether in a marketplace or in a poker game are rational and that they act at all times in accordance with their best interests. This is not borne out by reality. Any cursory historical account of human behavior belies that humans act rationally. Human beings are emotional actors as much as they are rational actors.

The supremacy of emotions to the human story is only matched by our social scientists willful neglect of them. However, given a choice, time and again, we often act on our emotions and against our rational interests. Our strongest emotions keep us awake at night, they cause us physical pain, they have helped our race to achieve beyond all expectation when at other times they have left us paralyzed. We think wishfully when we rationally should not. The markets are replete with examples of irrational exuberance, traders who act out of hope, fear and greed as much as they act out of a consistent rational interest in maximizing their profits. Markets historically at tops and bottoms have betrayed the irrational mob mentally of the masses of its participants.

If humans were truly rational, we simply would not have addictive behaviors like gambling, drug addiction, drinking or any self-destructive behavior. We may not even have much ill-health, skin cancer, road-rage, or obesity because knowing we should take care of ourselves, we would-this is rational. We may never purchase luxury items or clothes. We may not care so much about how our neighbors live because we would not feel envy, jealousy, sympathy or pity. The pursuit of leisure and charitable activities may well be quite different. So many of Tocqueville’s observations about American life would not hold water.

But in reality, half of our brains are devoted to pure emotion. And this half has expressed itself as the stuff of life. We cannot seem to choose our emotions one at a time either. If we were, we would want to be able to love with being vulnerable to grief, to experience the wings of hope without putting ourselves in danger of experiencing disappointment or the failure of our hoped-for event. As a race, we have spent most of our time acting on our emotions and being in their grip as is borne out in our history, our mythologies, culture, our wars and literature. It is in every sense human to be irrational or at least to experience emotion. To argue that humans are rational actors is at a minimum to simplify things, but really it is not a valid assumption.

Modeling also suffers from faulty assumptions about the ability of human participants to gather, assimilate and react to information. Most models are sensitive to information. Information causes the rational actor in a model to act a certain way, presumably in a way that will maximize that actor’s interests. In the real world, information is not perfect. There is misinformation. Rumors, false tips, erroneous analyst reports are example of misinformation. Some information that is available to a rational actor is false information. Even if we assumed that all the information available to market participants was correct and no false or misinformation was available, market participants would process and assimilate the information differently and at different rates. One example of misinformation and information assimilated at different times is the discovery of a report in 2008 on the internet that United Airlines was facing bankruptcy. This report was over a year old but it caused the price of the stock to drop by over 40% in a single day, before it was discovered that the report was old. In the real world, individually and collectively, we have different intellectual and ideological frameworks, we also have different levels of intelligence, among other factors that allow us to reach very different conclusions when faced with the same information. My neighbor may react to rising gasoline prices years faster than I would by immediately cutting down on his driving or purchasing a hybrid vehicle. Market participants react to identical information at various rates. One person may react quickly to too little information and another may wait much longer accumulating much more information. Sometimes waiting to act while accumulating and digesting information is not a good thing like waiting to liquidate a losing position before your losses wipe you out when acting sooner would have allowed you to cut your loss without going broke.

Another problem with financial models is that they do not account for insider information. One of the inherent conflicts in investment banks has been the Chinese wall that is supposed to separate the investment banking and sales functions of the investment house from the research and analysis side. Some have argued that this Chinese wall did not always exist. There is an inherent conflict between the need to sell the investment banking services of a bank to the same customer who is being covered by the bank’s analysts. If the analysts were too harsh in their coverage, then the ability of the bank to sell its investment banking services may suffer. What about the potentially insider information that the analysts obtained in covering a company and the danger that this information would travel across the room to the trading floor of the investment bank? Another conflict of interest certainly, but it is also an example of a market participant having insider information or simply information that other market participants do not have, before they have it.

Another fallacy with financial modeling is that models are required to isolate a fixed amount of causal variables. In other words, a financial model that was designed to predict the risk of an investment portfolio would be comprised of say twenty factors or variables, each of which or a certain number of which would affect a change in measure of risk to the investment portfolio. What if in reality, it was one hundred or ten thousand different variables or things that would change the riskiness of the portfolio?

The financial models of investment bank analysts assign likelihood to the possibility of certain events occurring. Financial models assume a normal distribution (a bell curve) of asset returns or risk. The belief that most market events occur in a normal distribution is the single key assumption made by many financial models, including the capital asset pricing model (CAPM) and the Black-Scholes option pricing model (BSM) and VAR. Using a normal distribution, events that diverge from the mean or center of the bell curve, by five or more standard deviations, known as a five-sigma event, are very rare and ten-sigma events are nearly impossible. However, the 1987 market crash represents a change of 22 standard deviations. The odds of such a 22 standard deviation event occurring are so low as to deemed impossible.

In the real financial markets, events considered nearly impossible by financial models assuming normal distributions of events, not only are possible, they are occurring frequently. There have been multiple fluctuations greater than five standard deviations in our most recent past.

Events that according to a Gaussian Bell Curve are supposed to occur only once every one hundred thousand years, if at all, are occurring in certain cases, several times in a decade. Plotting out these events, like our current credit crisis, the market crashes of 1987 and 2000, Long-Term Capital Management, the collapse of Bear Stearns, the Savings and Loan Crisis, the crash of 1929, the collapse of Northern Rock, the Russian Debt crisis, the 1997 Asian financial crisis, the 1990 Japanese asset bubble crisis, the 1973 oil crisis and 1978 energy crisis, etc. would lead to an unseemly looking bell curve-really it would hardly resemble a bell curve at all.

These impossibly unlikely events if plotted on chart would give an ordinarily symmetrical tidy looking Gaussian Bell Curve a very fat tail. Hence improbable or impossible crisis like our present credit crisis are called fat tails. A fat tail is an occurrence that is considered to be well outside the range of what is considered normal or possible.

Think of a fat tail happening in your own life as described by the writer Chevelle in Models and Agents as the occurrence of the following,

“It’s 10am, your rottweiler has just chewed your Italian leather boots, your wife has burnt your pancakes and your mistress is on the phone proclaiming that ‘it’s over because, really, you’re pretty lousy in bed.’ Oh yeah, and while you’re at it, your broker is leaving you a message that the stock market is crashing and you’ve lost a third of your savings. A bad hair day? No, my friend. You’re likely living in a fat tail!…It all began with what we call a probability distribution. Think of each day of your life as a dot under a bell-shaped curve: Most of the dots are concentrated around the middle, in the bulge of the bell: Days of medium pain and medium pleasure; boots are shiny, pancakes edible and mistress satisfied (at least that’s what you think!).”

Dramatic market events or fat tails do occur in a greater frequency than is possible assuming normal distributions suggesting distributions are not normal. Since the 1998 Russian debt crisis, the global financial markets have experienced at least 10 fat tails, none of which were supposed to occur more than once every few billion years.

Our models of the financial markets cannot anticipate the occurrence of fat tails and according to our present models, they are statistically so unlikely to occur as to be deemed essentially impossible. Where does this leave us? Why are we using them at all?

It may arguably be simple arrogance to believe a mathematical model can predict future history. Or as John Maynard Keynes wrote in his concluding paragraph on General Theory,

“Too large a proportion of mathematical economics are a mere concoction, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”

Alternatively, the answer may be that the financial services industry is full of at least two generations of analysts, investment bankers and statisticians, who have been indoctrinated through college and their MBA programs to believe in the bell curve and normal distributions.

Do we disregard the occurrence of catastrophic market events like the many we have experienced over the past twenty years alone, or should we critically examine the way we model risk and financial behavior? Perhaps the latter.*

The economic meltdown that faces President Obama is likely the most serious economic threat to the United States and the global financial markets since the Great Depression. In an effort to change the regulatory structure that set the stage for the current crisis, the House Committee on Agriculture passed The Derivatives Market Transparency Act of 2009 (“Derivatives Act”) this month.

Arguably, changes to the regulatory regime of the financial markets may be needed, one need only point to Bernard Madoff or R. Allen Stanford. However, any change to the way the Securities and Exchange Commission (“SEC”) or the Commodity Futures Trading Commission (“CFTC”) regulates the financial markets, must first address the ability of both these regulators to regulate. Neither the CFTC nor the SEC can regulate non-transparent markets- that is the markets in which the estimated $596 trillion[1] or more unregulated over-the-counter (“OTC”) derivatives including the $35-65 trillion in credit default swaps[2] that have played a role in the current credit crisis. Any change to the existing regulatory regime must address the need for transparency in the financial markets. Concepts like marking to market are essential to transparency, well functioning financial markets and to regulators. Moreover, the legislature, especially as the financial markets continue to teeter on the brink of further collapse, must be careful to avoid hasty legislation that may make matters worse.

The causes of the current worldwide credit/asset valuation crisis, which has led to the present economic meltdown of 2009 are many. But the chief suspects are a structural lack of transparency in the financial markets and an inherent problem in the way the financial system internally looks at risk. Unlike previous economic crisis, the credit crisis was not caused by any exigent force but by the financial markets themselves. The idea that market events are random and occur in normal distribution must for once and for all, be examined.

The current economic meltdown was caused by allowing regulated parties such as banks, pension funds and investment houses to use notional values and computer models to value assets instead of marking all securities to a regulated market. The current crisis was also caused by the inability of out risk models to handle events that fall outside of a normal distribution. That market events occur in a normal distribution is the key assumption made by many financial models, including the capital asset pricing model, the Black-Scholes option pricing model, and VaR. However, events, like our current credit crisis, the market crashes of 1987 and 2000, Long-Term Capital Management, the collapse of Bear Stearns, the Savings and Loan Crisis, the crash of 1929, the collapse of Northern Rock, the Russian Debt crisis, the 1997 Asian financial crisis, the 1990 Japanese asset bubble crisis, the 1973 oil crisis and 1978 energy crisis do not even remotely fit into a normal distribution. Our current models for evaluating risk are structurally

A. Marking to Market

Marking to market, the opposite of notional value, is a characteristic of the most transparent financial markets.

One of the provisions of the $700 billion dollar bailout bill that was passed by the House of Representatives on October 3, 2008[3] includes a provision that gives the Securities and Exchange Commission the right to suspend mark-to-market accounting under Statement Number 157 of the Financial Accounting Standards Board. In other words, the SEC would be allowed to suspend the use of mark to market accounting standards whenever it thinks the public’s interest would be best served by its doing so.

Mark-to-market, or “fair-value” accounting is cited as one of the principal reasons for the recent meltdown in the U.S. banking system. This accounting rule, which went into effect Nov. 15, 2007, forces financial institutions to put a fair value on their assets and liabilities each quarter.

This is not a novel regulation. Section 475 of the Internal Revenue Code has mandated the marking to market of securities at the end of each calendar year since 1983. Marking to market is being held responsible for erasing over $100 billion in assets tied to mortgage related securities. However, the principle of marking to market has existed in the futures markets since the beginning of price discovery by way of auction and open-outcry. Blaming the marking to market of securities for the current credit crisis confuses cause and effect. This is tantamount to blaming the scale for your weight problem.

This said, it was correct to suspend having to mark to market the value of securities and OTC derivatives during the height of the current financial crisis. Not doing so, may have resulted in a global market meltdown. Also, banks and counterparties would have been forced to liquidate securities at prices that have since risen.

Marked to market is more than an accounting rule; it is a principle that allows market participants to know the true value, the market value, of a financial instrument. Had the investment houses and counterparties more frequently had to mark the value of the mortgage related securities to market, the current credit crisis could have been averted, or at a minimum, the failing brokerage houses would have accurately accessed their financial situation long before bankruptcy.

All over the world at any given time, the value and the price of an S&P500 futures contract are known. Knowing the price of a contract contributes to liquidity-the ability to get in or out of a position held in a contract. The regulated futures market, long a stepchild of the financial markets, is the most liquid and transparent market in the world. It has been remarkably free from systemic financial crisis . . .with the exception of a certain salad oil scandal.

Perhaps there is a lesson here for Wall Street to learn. If you cannot mark to market, then trade at your peril, because you are in every way, trading in the dark.

Without marking to market, you cannot readily determine risk. For example, what price changes or variables will adversely affect the value of certain derivatives and at what point does a change in one or more of these other prices or variables make the counterparty or both counterparties to a derivative bear a loss that is at or beyond their risk parameters?

B. Transparency

Transparency refers to the degree of information that is available. In a perfectly transparent market all relevant information about a market transaction from the price, order size, order flow, trading volume, identity of the traders/counterparties, all bids and offers available, etc. would theoretically be discoverable.

The value of transparency in the marketplace is possibly best explained by its absence-opaqueness. The lack of transparency is called opaqueness. The environment that led to the current crisis was opaque. In the current mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth. The participants in instruments that led to this current crisis operated in a very opaque if not downright murky environment. The mortgage related securities being traded from brokers to banks and between banks were not pegged to the value of anything tangible. One could make the case that they were not even derivatives because their value was effectively not derived from an underlying anything.

All market transactions involve a degree of risk. In the law as in the markets, there is a presumption, albeit arguable, that the greater the amount of information a market participant has, the better able the participant is to assume and understand the risk behind the transaction.

Price is the single most relevant information provided in a transparent market. “What did you pay for that?” is more than vaguely related to “what is it worth?” While the price paid for a piece of art is often not a precise indicator of what it is worth, it is a good starting point. However, regardless of the price paid for a Monet or a November Soybean contract, the important question soon becomes, “what is it worth?” Soybean contracts are marked to market; owners could look at the spot or cash market and know immediately what the value of what they own. A stock portfolio of listed stocks has an immediately discoverable value because listed stocks are marked to market everyday as buyers and sellers determine what listed equities are worth at any given moment. The owner of a financial instrument unlike the owner of a Monet, has an after market to which he can go to instantly determine the value of the instrument and where he can sell it.

As we are now seeing, bad things can happen when the price of something is not known. In cases where financial instruments are not commoditized, regulated or listed, their value must be determined by the assignment of a notional value. Notional value can take on different meanings in various contexts. Notional value of many of the collateralized debt obligations (“CDO”) are created by one or more of the counterparties to the transactions. Worse, the notional value of a CDO or of a mortgage security bears no relation the market value.

It is argued that the notional value of unregulated securities transactions now exceeds $1 quadrillion ($1000 trillion). For collateralized CDOs the market value of the collateral may be much less than the notional value. Are they even collateralized?

In the case of Bear Stearns, many of the trading in mortgage related securities involved financial instruments assigned only a notional value. The failure of one of Wall Street’s most venerable investment houses and the largest bankruptcy in United States history that now threatens to shut down the banking system itself were caused by mortgage backed securities that were assigned notional values.

The current credit crisis on Wall Street is reminiscent of 1929 with a crucial difference-a lot more money at stake. Technology has at once increased the speed of transactions. In 2009, there are complex transactions involving derivatives whose notional values are in the hundreds of trillions of dollars.

There are several possible reasons why these transactions, which are in the author’s opinions only loosely termed, collateralized debt obligations, have become so popular. They are the product of what has become known from the late 1980s as financialization, the shift in the engines of economic growth away from manufacturing, production or even the service sector, to finance. Finance now accounts for the largest component of private sector GDP. GM and Ford make more from their financial services than from making cars, they have been losing money on making cars for some time. It is now the financial firms that are considered too big to fail. Many people point to the growth in private and public debt that occurred concurrently with financialization. During this same period, the profits of investment banks have grown tremendously.

However, a simpler explanation is self-interest. Trading in futures may be a zero-sum game. But there are some that would argue, wrongly, that trading in other derivatives is also a zero-sum game.

Trading in mortgage related securities has proven that with the use of notional value, each counterparty wins, at least for a while. Assume for example that a trader at investment house A is able to repackage and sell a package of mortgage related securities that he just bought to a trader at investment house B. Trader at investment house A cannot mark to market the value of what he just bought and sold because he would have to assess every component of underlying collateral for each mortgage included or underlying the securities. Perhaps he should also look at the FICA score of each of the mortgagers. The trader first most likely assigned a notional value out of thin air. In many cases, because the trader wanted to receive a bonus at the end of the year and show how much money he was making, the notional value he assigned to the securities he sold to the trader at investment house B was greater than the notional value he paid to buy them. In turn the trader at investment house B would have bought this basket of mortgage securities, repackaged them and sold them a notional profit to a trader at investment house C. And so on. One or more these traders may have been able to add another house in the Hamptons.

Warren Buffet remarked on the perils of marking derivatives according to the models of the counterparties that buy or sell them as opposed to having to mark them to market in Berkshire Hathaway’s 2002 Annual Report,

“Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth. I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.”

Regulation is not possible without transparency. But regulation without marking to market may not be possible at all. Currently, most of the hundreds of trillions of dollars of securities in existence not only have no market value, they are not subject to any regulatory oversight. Complex derivatives and swaps are exempt from regulation. Opaque instruments, with no value other than what is assigned by the computer-generated models of a self-interested counterparty, cannot be regulated.

C. Regulatory Background of Current Crisis

1. Glass-Steagel Act

It may be helpful to recall some history and perhaps the observation by George Bernard Shaw that, “If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.”

Shaw might just as well have been referring to the November 1999 decision by President Bill Clinton, led by Robert Rubin and Phil Gramm and supported by Alan Greenspan to sign into law the Gramm-Leach-Bliley Bill or the “Financial Modernization Act.” This bill repealed the Glass-Steegall Act and officially removed the prohibition that investment banks and commercial banks must be separate entities. Congress enacted Glass-Steegal in 1933 by an overwhelming majority to prevent a recurrence of the speculative frenzy that culminated in the Great Depression. Interestingly many of the banks, like Goldman Sachs and Morgan Stanley, that participated back then are participants in the current crisis.

Glass-Steegal separated the investment banking functions of banks from those of commercial banks. There is much to be said in favor of such separation. By definition, a commercial bank is a deposit-taking bank where an individual places money into a checking or savings account for the principal purpose of safekeeping and with the expectation of receiving interest. It is also an institution whose purpose is to loan money. A customer’s expectation that his money will be safe guarded is enhanced by the knowledge that the bank will not use the customer’s money to conduct speculative investment or deal making that would place the customer’s money at risk.

Customers prepared to take on more risk could invest money in any number of the financial products offered by an investment bank. But this would be the customer’s choice, not the bank’s.

But the main argument in favor of Glass-Steegal was the need to prevent a few mega banks from accumulating so much power that in the event of catastrophe or excess, Wall Street would not be plunged into another depression or credit crisis.

An unintended consequence of the repeal of Glass-Steegal Act in 1999 is that commercial banks became very much like hedge funds, investment banks and large speculators in the market. Commercial banks competed against investment banks for profits from investments and trading in an ever more mind-bendingly complex array of financial transactions.

Few people understand that the real fortunes on Wall Street, and principally in investment banks, are made between the wall and the wallpaper. This is a very fortunate place to find oneself because fortunes are made in fees. With each transaction, each counterparty booked a profit (albeit notional, but the reader should be getting used to the idea by now) but more importantly, each bank charged a fee, or many fees attached to each buy and to each sell, as the case may be. The investment banks made fees because every time a transaction is conducted on Wall Street, there is a fee to be made. An incentive is created to produce transactions for their own sake. New products or repackaged old ones, generate profit from fees. Everyone was winning until now.

But how, one may ask, was this allowed to happen? Was anyone minding the risk? It would be like an inveterate gambler who kept losing money but was able to determine his own limits with the house until one day he brought the house down. All the while the combination of insurance, investment banking functions, commercial banking functions created a growth in the conflicts of interests within banks that despite “firewalls,” seemed to multiply.

In a conflict of interest anecdote for the ages, Robert Rubin, who lobbied for the repeal of Glass-Steegal in his role as Secretary of the Treasury under President Clinton (what some Wall Street curmudgeons termed the “Citigroup Authorization Act”) stepped down from this position after its repeal to become Chairman of Citigroup’s Executive Committee at a starting salary of $40 million.

While Glass-Steegal did not cause the current crisis, had it not been repealed, Bear Stearns, AIG or Merrill Lynch and so many other banks would not have been allowed to have the kind of over-leveraged losing positions in mortgage backed securities (“MBS”) or CDOs that led to their collapse.

2. Shad-Johnson Jurisdictional Accord

The SEC and the CFTC entered into the Shad-Johnson Accord in 1982.

The Shad-Johnson Accord clarified the respective regulatory jurisdiction of both entities. It stated that all securities based derivatives products including options on securities, certificates of deposit and stock groups like exchange-traded funds would be exclusively regulated by the SEC. In turn the regulation and oversight of all futures and options on futures and on exempted securities and broad-based stock indexes was left to the CFTC. Single stock futures were banned under the Shad-Johnson Accord.

3. Commodity Futures Modernization Act of 2000

The Commodity Futures Modernization Act of 2000 (the “Act”) was

part of the Gramm-Leach-Bliley Bill or the “Financial Modernization Act.” The Act was signed into law by President Clinton on December 21, 2000. The Act amended the Shad Johnson Accord to allow for the trading of futures contracts on single stocks (single stock futures) and narrow-based stock indexes. Regulation and oversight of single stock futures would be shared by the CFTC and the SEC.

However, the most important change to happen as a result of the Act is its declaration that most OTC derivatives are exempt from the regulation or oversight of the CFTC.

By way of some background, the Commodity Exchange Act (“CEA”) holds that all futures contracts[4] be traded on a CFTC regulated exchange unless a statutory exclusion or regulatory exemption states otherwise. Prior to the Act, there was some legal ambiguity on whether the CFTC or the courts would announce that swaps and OTC derivatives are illegal because they are off-exchange traded futures contracts. The Act clarified an important grey area in futures law by stating that OTC derivatives and swaps of all kinds, were exempt from CFTC regulation.

Prior to the passage of the Act, swaps were considered functionally “hedges”, or risk-shifting transactions and as such under the jurisdiction of the CFTC. In 1993, the CFTC eased its regulation of swaps to exempt swaps whose terms were individually negotiated and not traded on computerized exchanges from the requirement that they be traded on a regulated exchange.[5]

The Act went further by expanding the definition of what constitutes a swap. It amended the CEA[6] to exclude from the jurisdiction of the CFTC any Swap Transaction broadly defined as any contract or agreement involving a non-agricultural commodity that is entered into between “Eligible Contract Participants”[7] and whose terms are not individually negotiated and is not traded on a Trading Facility[8]. Title II of the Act amended the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) by essentially removing all swap transactions from the definition of securities.[9] The Act left security-based swaps under the jurisdiction of the anti-fraud and anti-manipulations provisions of the Securities Act and the material nonpublic information provisions and insider trading provisions of the Exchange Act.[10]

What is exempt from regulation dwarfs the largely regulated global financial capital markets. The notional amounts outstanding of (OTC) derivatives continued to expand in the first half of 2008, with all types of OTC contracts standing at $683.7 trillion.[11] By contrast, the total size of the all world’s capital or stock markets combined is quoted as $118 trillion.[12] It would seem that the regulatory loop-hope created by the Act makes the size of the regulated market look like a toothpick on a pie.

4. Derivatives Market Transparency and Accountability Act of 2009

The Derivatives Act states its purpose as being “to bring greater transparency and accountability to commodity markets.” This article will address three major dictates of the Derivatives Act ostensibly drafted to bring about transparency and accountability: (1) a ban on “naked” credit default swaps[13]; (2) trading limits to prevent speculative excess[14], and (3) mandatory clearing[15].

The former Chairman of the SEC, Christopher Cox, after the collapse of Lehman Brothers in September 2008, announced that credit default swaps[16] were not only a way to evade short-selling rules in the equity markets but that they were also responsible for the current credit crisis.[17] This may not be entirely true.

In their most simple terms, credit default swaps are wagers that a company will fail. They are a hedging mechanism. However, they are not insurance and are, distinct from insurance contracts, they transfer the risk of failure without actually having to go through the failure. Credit default contracts are akin to life insurance policies that do not require that someone close to you actually die. What they do, even in their much-maligned current state, is allow for risk transfer between willing parties. They are also a way for the public to short corporate bonds, which other wise cannot be shorted.

What has given credit default swaps a particularly bad name in the current crisis is their lack of transparency. They are not marked to market and their value, in many instances, is not known. But on the scheme of things, this is not that bad of a problem. Assuming that the parties to a credit default swap are able to account for the worst-case risk scenario, the lack of transparency would not necessarily be problematic. What is more problematic is that the sellers of credit default swaps, as in the case of AIG, did not themselves adequately understand their risk when they issued credit default swaps. They did not have good risk models.

The users of credit default swaps did not have nearly adequate risk models. The contracts themselves, while not susceptible to regulation because of their lack of transparency, are not inherently bad, if the counterparties to the contracts understood the risk of the contracts-which in so many cases and so famously it has turned out, they did not.

Section 6 of the Derivatives Act calls for the imposition of trading limits on Designated Contract Markets[18], Designated Transaction Execution Facilities[19], other electronic trading facilities and Foreign Boards of Trade. This provision is interesting in that it appears to be a red herring.

Position limits have historically been imposed to prevent market manipulation (cornering of the market, one or more large speculator having an inordinate effect on price), to enhance liquidity and to promote an orderly delivery of a physical contract. It is difficult to decipher the logic behind this Section. However, a reading of the testimony before the House Agriculture Committee on the Derivatives Act offers some clues. In his written testimony before the Agriculture Committee, Professor Michael Greenberger of the University of Maryland Law School writes that Section 6 should be enacted in a wholesale manner without further study because of the “overwhelming evidence that has been gathered about the impact of excessive speculation on the energy futures and energy swaps markets.”[20] Presumably, the idea that higher energy prices in the futures markets were the result of excess speculation may have led the legislature to conclude that position limits should be imposed on heretofore unregulated, OTC derivatives and on all commodities. The logic is difficult to follow.

However, one of the unintended consequences of this seemingly illogical part of the Derivatives Act would be to deter price discovery and even trading on domestic exchanges. Trading in commodities and in OTC derivatives may simply move off-shore given that in 2009 so much of the world’s financial markets are inter-linked and in effectively, global. This Section may hurt the remaining domestic exchanges.

Section 13 of the Derivatives Act seeks to impose the mandatory clearing of all credit default swap contracts, effectively repealing the Act. The regulated futures markets have long stood as a paradigm of well functioning transparent, and problem free markets. If credit default swaps were listed and traded on regulated domestic exchanges, you would have transparency and they would be marked to market and most of all-they would not be the pariahs of the financial world that they now are, blamed for the current credit crisis and by extension the global economic meltdown. CME Group and Citadel have announced their intention to form a credit default swaps exchange as has the Intercontinental Exchange (ICE), NYSE Euronext and the Eurex.

The regulated futures markets are a great model. There has been an outcry to require the clearing and regulation of all OTC derivatives. Ideally, this would seem to prevent derivatives from ever again being the financial weapons of mass destruction Warren Buffet called them. However, credit default swaps, unlike all regulated and listed futures contracts are not standardized in their terms and they cannot be cleared.

Credit default swaps cannot by definition be standardized because their terms are individually negotiated and customized by the counter-parties. The very fact that we enact legislation stating that they must be cleared on a regulated exchange will not make them so. This Section of the Derivatives Act is somewhat counter-factual. Indeed requiring the clearing of what are now all OTC derivatives may well have the effect of moving the trading of OTC derivatives to foreign exchanges and making matters worse by hurting our existing domestic exchanges.

The current economic crisis was not ironically caused by a failure of regulation. Perhaps the Legislature should institute a regulatory scheme that would enforce the same regulations on the essentially hundreds of trillions of securities out there that are presently and effectively completely unregulated vis a vis all listed and regulated equity and derivatives products but this cannot be done in haste and the Derivatives Act is not the answer. OTC derivatives however do not lend themselves to regulation simply because they are so customized and cannot be standardized for clearing purposes. In many ways, credit default swaps resemble legal contracts more than they resemble listed futures contracts.

A better approach for the government regulators may well be to look much more closely at the balance sheets of the financial institutions that they already regulate. By keeping a hawkish eye on the use of leverage by all regulated financial entities, including banks and insurance companies, the SEC and the CFTC could at least in theory, catch speculative excess before it reaches Main Street.

Excessive deregulation, however, has not precisely helped either. Since the 1980s and for the almost three decades since, Washington has adopted the belief that the markets self-regulate perfectly if only the government regulators leave it alone. During this time, Wall Street ran amock with investments and trades in an alphabet soup of financial instruments or ever increasing complexity, often times in pursuit of fees and financial concoctions for their own sake. The idea that Wall Street would self-regulate and correct its own mistakes is simply not true, as the world painfully learned after September 15, 2008. Just because regulations have at times impeded the market does not mean that we should abandon all regulation. As the current credit crisis proves, just because regulations are not perfect, does not mean that the markets are either.

The larger problem lies at the cause of this current crisis and it is a structural problem within our financial system and one that was caused by our financial system itself. Wall Street must look at the way it thinks about risk. Risk is a funny notion but it is not notional, it is real. Between the time we have bubbles and financial debacles, talking about risk is a little like talking about the existence of God-or talking to a teenager about growing old. In a go-go atmosphere of notional value and financial obfuscation, the environment that bred the current credit crisis, risk was never a polite topic of conversation. It is now time to have it.

If Wall Street does not adjust its risk models they are allowing the table to be set for the next round of crisis, after memories of this one are beginning to fade, the time when the remainder of the hundreds of trillion dollars in securities with only notional values, come into play. A scenario that would portend badly for the banking system and the global financial system because it would herald the coming of losses once and for all greater than the entire global financial system’s ability to fix.

Dramatic market events occur at a greater frequency than is possible assuming normal distributions. Since the 1998 Russian debt crisis, the global financial markets have experienced at least 10 extreme events, none of which were supposed to occur more than once every few billion years. Our models of the financial markets do not anticipate the occurrence of extreme events and according to our present models, they are statistically so unlikely to occur as to be deemed essentially impossible. Where does this leave us? Why are we using them at all?

[8] Trading Facility under the CEA means, a person or group or persons that constitutes, maintains, or provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts or transactions by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, but does not include; a facility that permits participants to negotiate bilateral transactions through communications exchanged by participants (as distinguished from the interaction of multiple bids and offers), or certain activities of government securities dealers and brokers.

[9] Section 2A(a),(b)(1) of the Securities Act; Section 3A(a)(b)(1) of the Exchange Act.

[10] Section 2A(b)(4) of the Securities Act; Section 3A(b)(4) of the Exchange Act.

[16] “Naked” credit default swaps are also called naked shorts on public companies because they are contracts or wagers on the financial failure of a company or enterprise. Credit default swaps that occur to hedge an event that will actually occur and in which the holder of the contract suffers an actual loss are presumed by many to not to be “naked,” but actual hedges.

[18] Designated Contract Markets are boards of trade or exchanges that operate under the regulatory oversight of the CFTC, pursuant to Section 5 of the Commodity Exchange Act (CEA), 7 USC 7. They are like traditional futures exchanges, which may allow access to their facilities by all types of traders, including retail customers.

Are the United States Treasury, along with the Executive and Legislative branches looking everywhere but at the causes of the financial crisis in a rush to reform our regulatory regime and generally cure the crisis? Might the cure be worse in the long run?

There many culprits behind the current financial crisis including, excessive leverage combined with opaque instruments, a lack of transparency, conflicts of interest, credit ratings agencies, and a systemic flaw in Wall Street’s own risk models and the assumptions underlying risk models. However, it does not seem that the causes of the current crisis have yet been addressed in the hearings before the House or in the pronouncements of the Treasury Secretary. Are we instead focusing on the twin red herrings of mark-to-market accounting rules and short selling?

The Financial Accounting Standards Board announced August 13, 2009 that it will expand fair-value accounting to loans. Presently accounting rules only requires companies to value potential loan losses only when they are seen as probable-allowing the recognition of loan losses to be postponed. It would seem that financial institutions, especially banks, ought to use mark-to-market accounting rules or alternatively list difficult to value securities on public exchanges. Albeit in the case of highly customized agreements (OTC derivatives between private sophisticated parties), it may never be possible to list these transaction on an exchange.

The SEC recently entertained announcing proposals to permanently restrict traders from short selling. This comes on the heels of recommendation by the House to suspend mark-to-market rules. It is this lawyer’s humble opinion that the long-term solution to the current global financial crisis does not rest in piecemeal hasty legislation made under intense political lobbying pressure like the suspension of mark-to-market by the Financial Accounting Standards Board under possible pressure by large banks or short selling by the SEC. Neither mark-to-market accounting rules nor short selling caused the current financial crisis.

Short selling is a useful tool for market participants as a source of liquidity, and a risk transfer and hedging mechanism. It is an essential risk transfer mechanism that enables skeptical traders or the public to wager against publicly traded companies. Short selling transfers the risk of failure without actually necessitating a failure. It provides necessary liquidity to the financial markets.

Mark-to-market is more than an accounting rule; it is a principle that allows market participants to know the true value, the market value, of a financial instrument. Marking to market fosters transparency. As long as investors do not have the timely prices by which they can evaluate their decisions, as is often the case in the private OTC market, the market remains frozen.

Remember that the value of transparency in the marketplace is possibly best explained by its absence-opaqueness. The lack of transparency is called opaqueness. The environment that led to the current crisis was opaque. In the current mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth. The participants in instruments that led to this current crisis operated in a very opaque if not downright murky environment.

Price is the single most relevant information provided in a transparent market. Eliminating the requirement that assets be marked to market will result in their being marked to model…or as Warren Buffett remarked, “market to myth.”

The regulated futures market, long a stepchild of the financial markets, is the most liquid and transparent market in the world. It has been remarkably free from systemic financial crisis and there is a lesson there.

In my opinion, transparency, strict accounting rules and the ability to short sell are characteristics of the most efficient financial markets. Easing accounting standards may set the stage for the opposite of transparency, that is financial obfuscation, and in the long run, the very real possibility of future financial crisis.*

This is an example of a WordPress page, you could edit this to put information about yourself or your site so readers know where you are coming from. You can create as many pages like this one or sub-pages as you like and manage all of your content inside of ... Continue reading →